The global financial crisis forced governments facing failing financial institutions to choose between disorderly bankruptcies and costly injections of public funds. This column argues that special resolution regimes are a better alternative. It analyses their structure and function and argues EU member states ought to introduce and strengthen such regimes.

The recent financial crisis made evident the absence or inadequate scope of resolution tools to deal with failing financial institutions across the globe. Authorities were often confined to two alternatives:

corporate bankruptcy, as chosen for instance by the US authorities in the case of Lehman Brothers, a global financial-services firm, and

an injection of public funds, as chosen by the US authorities in the case of AIG.

Events have shown that both these options can be very costly. A disorderly bankruptcy (as in the case of Lehman Brothers) can magnify the systemic impacts of the failure of a financial institution. When the authorities aim to avoid these impacts by injecting capital to support the institution (as in the case of AIG, or in the German cases of Hypo Real Estate and IKB), an open-ended commitment has been shown to require large fiscal outlays. A special resolution regime would allow authorities to avoid the choice between “disorderly bankruptcy” and “injection of public funds”, thus improving efficiency by containing both fiscal costs and systemic impact.

Figure 1. Fiscal cost and systemic impact in resolution regimes

Indeed, for example, the efficient solution may involve a sale of the institution to another financial institution as a going concern. However, existing shareholders – either large blockholders or the majority of small shareholders – may hold out and block the resolution option taken by the authorities. This is likely to happen whenever the resolution option involves a loss of value or a loss of control for existing shareholders. The cases of Fortis and HRE are examples in which shareholder control delayed or closed off the resolution path preferred by the authorities.

Absence of special resolution frameworks not only encumbers crisis management; it may also have longer-term effects on financial stability. When ordinary bankruptcy is viewed as too costly by the authorities, bankruptcy ceases to be a credible threat. But if public infusion of capital becomes the only tool, this is certain to create moral hazard and reduce the force of market discipline (Nier and Baumann 2006).

In Canada, Japan, and the US, special resolution regimes for banking firms have long been in place and used effectively by supervisory agencies in many cases. Recent proposals by the US Treasury Department envisage extension of special resolution powers to non-bank financial groups of systemic importance. By contrast, in many European countries, bank resolution is based on the general insolvency law and is often administered by the courts, with bank-specific modifications varying widely across countries. In response to the crisis experience, some EU countries are either in the process of reviewing (e.g. Germany) or have recently revised (e.g. the UK) the relevant legislation. In other countries, the obstacles to legal reform still loom large.

Revising national frameworks for the resolution of financial institutions may be in the interest of each member state and the EU as a whole. The absence of robust resolution frameworks increases the likelihood that national authorities will resort to propping up failing financial institutions. Such support may conflict with the general principle underlying Articles 92–94 of the Treaty of Rome that state aid distorts competition and runs counter to a common market. It will also tend to increase the total fiscal cost of crisis resolution in the region as a whole.

Principles and design of the framework

A consensus is beginning to emerge about the features that a special resolution framework should comprise. In particular, sound practice is for the framework to

allow the banking authorities to take control of the financial institution at an early stage of its financial difficulties through “official administration”,

empower the authorities to use a wide range of tools to deal with a failing financial institution, without the consent of shareholders or creditors,

establish an effective and specialised framework for liquidation of the institution that assigns a central role to the authorities and effectively protects depositors,

ensure clarity as to the objectives of the regime, including preserving financial stability, and the scope of judicial review,

promote information sharing and coordination among all authorities involved in supervision and resolution.

Effective resolution needs to expand the set of tools available to authorities in the resolution phase beyond the “default options” of liquidation and capital support. The following tools have been found particularly useful:

acquisition by a private-sector purchaser,

a bridge bank (a temporary institution created by the resolution authority to take over the operation of the failing institution and preserve its going concern value),

partial transfer of deposits and assets to a “good bank”, and

temporary public control, as a last resort.

The resolution regime will need to specify a regulatory threshold, such that when the threshold is crossed, the resolution authority is entitled to take control of the firm and to use resolution tools at an early stage of financial difficulty when the institution may still have positive net worth. This can be a hard trigger, such as the breach of a specific regulatory ratio, but it might also be a soft trigger, enabling a number of considerations to inform the policy judgment.

The resolution framework needs to be consistent with the general considerations that govern the conditions under which personal property rights can be constrained by the authorities. This will in general require an overriding public policy objective, such as the preservation of financial stability. Judicial review of actions taken by the authorities should be clearly circumscribed and should not allow the court to reassess the exercise of discretion unless there is clear evidence of a manifest error of fact or an abuse of power. Where the relevant actions of the banking authorities inflict damage on a bank’s owners without proper justification, the remedy can be in the form of monetary compensation. However, the legal framework should establish clear limits on the circumstances in which such damages may be awarded, and it should grant immunity for banking authority officials from liability for actions they have taken in good faith.

Introduction of special resolution regimes requires careful reflection of the appropriate scope of the regime. At a minimum, all deposit-taking institutions need to be within the scope of the regime. It may be desirable for the scope to be robust to a potential trend away from business models that involve funding through retail deposits and to apply more broadly to financial institutions that can pose a systemic risk, as per suitably defined criteria.

Cross-border issues

The introduction of special resolution regimes at the national level could be a useful element to help achieve a more effective resolution of financial institutions operating across European borders. By virtue of the Winding-Up Directive, resolution actions taken by authorities in accordance with their national (special) resolution framework have full legal force across the EU, in cases where the failing institutions has branches in other member states. When the failing institution has subsidiaries, this does not hold necessarily. Nonetheless, even in these cases, special resolution regimes are likely to have positive effect on the cross-border resolution, namely:

An effective regime will tend to reduce the fiscal burden involved in resolution, making it more likely for national authorities to agree on sharing the burden.

Special resolution regimes are likely to reduce difficulties associated with situations where the subsidiary is systemic in a host country, but the parent is not considered systemic in the home country. If a special resolution regime were in place that would provide the home authorities with the power to effect a forced sale of the institution, the home authorities could well judge that the cost of using this option is small relative to the cost of letting the institution fail, with benefits to the host economy.

The “bridge bank” is likely to be helpful as an interim solution in complicated cross-border cases, when negotiating a permanent solution may be time consuming.

National special resolution regimes may not be sufficient to fully address cross-border issues. They may need to be complemented by an EU-level special resolution regime for cross-border institutions. A resolution regime that applies at the fully consolidated level may come to be an element in a dedicated European regime for cross-border financial institutions (Čihák and Decressin 2007). While this is a useful medium-term goal, a realistic approach at the current stage is for the European authorities to encourage individual EU countries to introduce or strengthen their national frameworks, which are needed in any case.

Conclusion

Summarising our analysis, there is a strong case for banks and other systemically important financial institutions to be subject to a special resolution regime (Čihák and Nier 2009). Such regimes can contribute to overall financial stability by improving the trade-off between the need to stabilise the banking system and to minimise fiscal costs and longer run-costs of moral hazard. They can thus help restore incentives that are otherwise compromised by expectations of public support, “too important to fail”.

Special resolution regimes are not, however, sufficient to guarantee financial stability. Successful financial stability frameworks rest instead on a range of interlocking measures, including special resolution regimes, as well as heightened prudential control of systemically important institutions (Nier 2009). Indeed, in the absence of special resolution tools, even relatively small institutions can pose a threat to financial stability, potentially requiring much tighter prudential controls of large parts of the financial system to achieve a given stability goal. When the objective is to ensure that the financial system is both stable and efficient, the introduction of special resolution regimes needs therefore be a key priority.

Disclaimer: The views expressed here are those of the authors and not necessarily those of the IMF.